Author: Keiichiro Kobayashi, Keio University

The long-lasting effects of a financial crisis on the real economy are a puzzle, as the crisis by nature is a short-run event. As Kozlowski, Veldkamp, and Venkateswaran (2016) argue, the existing explanations assume that the shocks that trigger a persistent recession are continuous. Kozlowski et al. give another explanation that a one-time crisis changes people’s expectations of tail risks indefinitely. In this column, we focus on another persistent change in the real economy due to short-run financial crises, which is the accumulation of huge amounts of excessive debt in firms and households. We argue in what follows that a one-time buildup of excessive debt can depress the economy interminably even if there is no change in financial technology, based on our theoretical study (Kobayashi and Shirai 2017).

Whether or not the buildup of debt can cause a persistent recession is of practical importance when we assess policy recommendations. If persistent stagnation is due to exogenous technological shocks (e.g., Gertler and Kiyotaki 2010, Christiano, Eichenbaum and Trabandt 2015) or an unwavering change in expectations of tail risks (Kozlowski et al. 2015), policymakers can mitigate a recession simply by accommodative monetary and fiscal policies, because they can do nothing directly to eliminate exogenous shocks or expectations of tail risks. If, on the contrary, a recession is due to accumulation of excessive debt, they can cure it by simply reducing debt. Debt reduction is not necessarily the liquidation of overly indebted borrowers, but may be just their relief from debt by debt forgiveness or debt-for-equity conversions. Even in this case, unconventional monetary and fiscal policies may be effective to mitigate the severity of recessions, whereas their ultimate function is to buy time and not to cure the recession itself. At the least, we can say that if excessive debt is the problem behind a persistent stagnation, it may be necessary to expand choices for policymakers. Choosing among monetary easing, fiscal policy, and ex ante macro-prudential regulations may not be a satisfactory framework for policy debate, but we may need to explicitly compare them with ex post policy measures to accelerate debt reduction in the private sector.

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